We sometimes hear 1031 Exchanges being referred to as tax “free.” This is a misconception that we want to clarify with you, because we don't want you to have any false expectations.
1031 Exchanges are tax-deferred, which means you are putting taxes off to a future period. Should you decide to sell your replacement property at a later date outside of a 1031 exchange, that’s when you will see those taxes appear again, and will be subject to pay them.
A lot of times when folks hear this, they ask why do a 1031 Exchange then? The reason is to use the portion of the sale that was originally intended to pay the capital gains tax and instead use it for other purposes—possibly buying new furnishings for the replacement property, adding improvements, or even paying off credit card debt. Maybe you want to use those funds now to take that lifelong dream trip of traveling Europe. Who knows! The point is, by doing a 1031 Exchange and deferring the taxes, you are able to use those funds in a way you choose.
Even better, there are ways to continue to defer the tax and essentially not have to pay it. One way would be to hold on to the replacement property. The IRS sees a sale as a taxable event—therefore, if you don't sell it, there is no event for them to tax you on and acquire those deferred taxes. If you hold onto that property until you die and gift it to your heirs, it will then be tax free to the beneficiary.
What if you know you don't want to hold onto this property forever, and you eventually want to sell it and reinvest in another property? As long as you continue to do a 1031 and roll over your properties, you will still be deferring the taxes. You can continue to do this as many times as you’d like, as long as you are selling within the guidelines of a 1031 exchange, and you will continue to defer the taxes until you die.
If you have any questions about deferring taxes in a 1031, please give us a call. We’d be happy to consult with you!